I am away from this blog working hard on projects that I hope will be of value to my readers as soon as it is possible and permissable to publish them. But in the meantime just had to blog on how painfully iterative, nay repetitive are the debates we are having now on the deficit, and on the need for government to intervene to lift the economy out of what the NIESR apparently defines as ‘depression’…(See David Blanchflower on ‘why this could be the longest recession in 100 years’ in the New Statesman.) I am stung into doing this by the number of Hayekians that are attacking the piece “Happy Anniversary Mr Keynes” that Prof. Chick and I posted first on Bloomberg, but then on the Huffington Post.
But first let me emphasize this: Keynes always regarded government intervention as a last resort: as action that must be taken in the event of financial crisis, and the economic failure of the private sector, a collapse in output and rising and unsustainable unemployment. All his work was geared towards preventing that happening…The fact that he is now exclusively tarred with the ‘government spending’ brush – is the result of a) the ruin of the global economy and therefore the need for government intervention and b) his enemies framing his policies as exclusively about an emergency reaction to crisis, not by the pro-active theories and policy proposals in the General Theory itself.
Keynes’s overwhelming concern was with ending ‘liberal finance’ – de-regulated capital mobility and credit creation at high rates of interest by an unrestrained private banking sector. This is the part of his General Theory that has been buried – and should we be surprised at that? Of course not…..
This is why his argument has to be continually re-stated, as I am trying to do now in a commissioned paper which I hope soon to share. It is this: that in a monetary economy (as opposed to say a barter economy) saving, which is another word for non-consumption, or delayed consumption, is not necessary prior to investment. The state, corporations, households, individuals do not need to save, in order to be able to invest in public services, in new, risky enterprises or in treating people with Alzheimer’s disease.
I, and no doubt you, dear reader, were trained to think the reverse. That the state, individuals, corporations, society needed to save in order to be able to invest…..I was taught that the UK first set aside 5% of its income back in the 18th century, and it was only that saving that allowed investment and development to take place….Countries without such a record of saving, it was argued, could not advance in ways that countries with high rates of savings advanced.
The economic theory that saving is necessary prior to investment is dominant. It came about, in part, because banks in Victorian times were not adequate to the demands of rapid industrialisation, and firms could not easily raise funds for large-scale investment. Instead they relied on the savings of individuals. The saving habits of the time were therefore incorporated into Classical or Victorian economics. They persist to this day in neo-classical economic theory – still dominant in our universities and think-tanks.
For the Victorians, banks were merely channels, passing money from lenders to borrowers; from individuals to firms and governments. But as the banking system evolved, banks were able to create credit in excess of savings. With time it became clear that neither savings, nor prudent savers were necessary or essential for investment. Thanks to credit-creation by the banking system, investment was no longer constrained by saving.
This was a remarkable and very welcome – if nevertheless dangerous – development. Indeed capitalism owes much of its advance to the development of sound banking systems.
After the invention of bank money, to the astonishment and delight of many, money was no longer a scarce resource. Economic activity was no longer bound up with, and dependent on the elites with savings in excess of income. Bank money provided a mechanism for lending that precisely did not depend on the generosity of individuals holding savings towards those who did not have savings. As a result, bank money widened and democratised the allocation of credit.
This was indeed a liberating and great social advance.
Bank money had a second great advantage, the very thing that had motivated its invention: lower interest rates. The increased supply of credit for investment, lowered its ‘price’ – the rate of interest. As Karl Marx noted:
“The development of the credit system takes place as a reaction against usury…..this violent fight against usury…robs usurer’s capital of its monopoly by concentrating all fallow money reserves and throwing them on the money-market…”
Today, the banking system has advanced even further. For investors that operate in monetary economies, the relevant consideration is the availability of finance, not savings, and there need be no constraint on finance – because credit is not a commodity and there need be no limit to its creation. Unlike gold or oil, it is not subject to the laws of supply and demand. And because it is not subject to the laws of supply and demand, its price – or the rate of interest – is necessarily a social construct. In other words, the price of credit is influenced not by shortages or gluts, but above all by committees of men and women, based in central banks, and in the private banking system, who gather periodically to determine the most appropriate rates of interest for the economy, or for the private banking sector.
Right now the committee at the Bank of England has set base rates low, but committees at the British Bankers Association and within banks themselves, set much, much higher rates. HSBC wrote to me to say that there would be 0% interest on my deposit of £3,000.00; but if I dared move into overdraft, the rate would be 26%! That’s what I call a very good spread.
It explains why demand for loans is ‘muted’- to quote the bankers – because the prices/rates of interest on those loans are usurious – i.e. unpayable! Not just by sub-prime borrowers, but by entrepreneurs and other firms. Hence their reluctance to borrow. (For more on usuriously high rates see this piece by Jill Treanor: “Lenders rake in profits..”
In their Project Merlin agreement with the government, the banks ‘anticipate the further impact on demand of the higher cost of lending arising from increasing capital and liquidity requirements.”….In other words the banks are blaming muted demand caused by their exorbitant loan rates on the Basel agreements..and the government includes that pathetic excuse in its agreement……What tosh!
What is most distressing about Project Merlin is that those Treasury negotiators that Lord Oakeshott rightly argued could not negotiate their way out of a paper bag, did not even raise the question of lending rates! In other words, the Treasury position can be defined as: please keep lending, bankers, to heavily indebted and deeply reluctant corporate and individual borrowers, and of course we will turn a blind eye to whatever rate you apply to squeeze their pips, even while we recognise that your usury will exacerbate the collapse in investment further!
To return to the main theme: the creation of bank money by sound banking systems is always based on confidence and trust, and is created in the first instance as credit. To make loans, banks do not have “savings” or “deposits” – either theirs, or those of others – to extend to others as credit, and on which they charge interest. The money for a bank loan does not exist until we, the customers, apply for credit.
We do not need savings to encourage investment.
In brief: credit created by the banking system creates economic activity. Economic activity generates income (to repay the debt) and then savings, and is not constrained by savings.
However, what is critical is that first: credit creation should be carefully regulated to ensure that it is aimed at productive activity – activity that will generate income. Second, Keynes was absolutely clear: rates of interest – across the spectrum of loans, short and long, real, safe and risky – must be kept very, very low – to make debt repayable.
For central banks to enforce low rates across the spectrum, requires regulation of capital mobility. And it is this central tenet of Keynes’s theory that is most controversial with …..I will leave you to guess…..and their apologists in the economics profession and the political class. For evidence of this, I am including below the letter that Hayek and colleagues wrote to the Times in 1932….You will see that Hayek’s gravest concern is with Keynes’s proposals for ” restrictions on trade and the free movement of capital (including restrictions on new issues) which” he and his colleagues argued “are at present impeding even the beginning of recovery.”
TO THE EDITOR OF THE TIMES
Sir, the question whether to save or whether to spend which has been raised in your columns, is not unambiguous. It involves three separate issues: (1) Whether to use money or whether to hoard it; (2) whether to spend money or whether to invest it; (3) whether Government investment is on all fours with investment by private individuals. While we do not wish to over-stress the nature of our differences with those of our professional colleagues who have already written to you on these subjects, yet on certain points that difference is sufficiently great to make the expression of an alternative view desirable.
(1) On the first issue — whether to use one’s money or whether to hoard it — there is no important difference between us. It is agreed that hording money, whether in cash or in idle balances, is deflationary in its effects. No one thinks that deflation is in itself desirable.
(2) On the question whether to spend or whether to invest our position is different from that of the signatories [Pigou, Keynes et al] of the letter which appeared in your columns on Monday. They appear to hold that it is a matter of indifference as regards the prospects of revival whether money is spent on consumption or on real investment. We, on the contrary, believe that one of the main difficulties of the world today is a deficiency of investment — a depression of the industries making for capital extension, etc., rather than of the industries making directly for consumption. Hence we regard a revival of investment as peculiarly desirable. The signatories of the letter referred to, however, appear to deprecate the purchase of existing securities on the ground that there is no guarantee that the money will find its way into real investment. We cannot endorse this view. Under modern conditions the security markets are an indispensable part of the mechanism of investment. A rise in the value of old securities is an indispensable preliminary to the flotation of new issues. The existence of a lag between the revival in old securities and revival elsewhere is not questioned. But we should regard it as little short of a disaster if the public should infer from what has been said that the purchase of existing securities and the placing of deposits in building societies, etc., were at the present time contrary to public interest or that the sale of securities or the withdrawal of such deposits would assist the coming recovery. It is perilous in the extreme to say anything which may still further weaken the habit of private saving.
But it is perhaps on the third question — the question whether this is an appropriate time for State and municipal authorities to extend their expenditure — that our difference with the signatories of the letter is most acute. On this point we find ourselves in agreement with your leading article on Monday. We are of the opinion that many of the troubles of the world at the present time are due to imprudent borrowing and spending on the part of the public authorities. We do not desire to see a renewal of such practices. At best they mortgage the Budgets of the future, and they tend to drive up the rate of interest — a process which is surely particularly undesirable at this juncture, when the revival of the supply of capital to private industry is an admitted urgent necessity. The depression has abundantly shown that the existence of public debt on a large scale imposes frictions and obstacles to readjustment very much greater than the frictions and obstacles imposed by the existence of private debt. Hence we cannot agree with the signatories of the letter that this is a time for new municipal swimming baths, etc., merely because people “feel they want” such amenities.
If the Government wish to help revival, the right way for them to proceed is, not to revert to their old habits of lavish expenditure, but to abolish those restrictions on trade and the free movement of capital (including restrictions on new issues) which are at present impeding even the beginning of recovery.
We are, Sir, your obedient servants,
T. E. Gregory, F. A. von Hayek, Arnold Plant, Lionel Robbins
The letters appeared in the month of October, 1932. Keynes won the argument then, and for the whole duration of the ‘Golden Age’ – 1946-71…..but his arguments are now lost.